To the surprise (and dismay) of taxpayers and practitioners, Congress has been unable to repeal or defer the requirement to capitalize and amortize research and experimental (R&E) expenses under Internal Revenue Code Section 174. While there was strong bipartisan support, and a huge lobbying effort from many different industry groups, Congress was unable to pass legislation addressing the issue before the year and does not appear ready to address tax matters anytime soon. This could have negative tax impacts for U.S. businesses, especially manufacturers and distributors.
The Tax Cuts and Jobs Act of 2017 (TCJA) included a provision, which was effective for tax years beginning after December 31, 2021, requiring the capitalization and amortization of R&E expenses. Prior to this, such expenses were allowed to be deducted as incurred. The amortization period is five years for domestic research expenses and fifteen years for foreign research expenses. In year one, the mid-year convention is followed, therefore only ½ of the annual amortization expense is recognized in the first year. The TCJA also specifically added software development to the definition of R&D expenditures under Section 174.
Is the Research Credit Impacted?
This change impacts any taxpayer with R&E expenses. There are no de minimis exceptions included in Section 174. R&E expenses include all expenses incurred for activities intended to discover information that would eliminate the uncertainty concerning the development or improvement of a product.
The impact of the capitalization is merely a deferral of the deduction; however, the current impact can be quite significant. Consider the below comparison for a company treated as an S Corp or partnership for tax purposes. The example below assumes a 6% state tax rate.
|2021 – Full Expensing||2022 – Capitalize and Amortize|
|Total Income Before R&E Expenses||$2,500,000||$2,500,000|
|Amortization of Capitalized R&E||($50,000)|
|Net Taxable Income||$2,000,000||$2,450,000|
|Federal Tax (29.6%)||$592,000||$725,200|
|State Tax (6%)||$120,000||$147,000|
|Total Tax Due||$712,000||$899,200|
In the above example, the taxpayer’s tax liability is over 25% more due to the change in legislation when compared to the prior year. For many taxpayers, especially those with heavy R&E activity, the results could be even more significant.
Is Section 174 Capitalization Mandatory?
The research credit under Section 41 is not impacted by the requirement to capitalize Section 174 expenses. To qualify for the research credit, expenses must first meet the definition under Section 174. Once expenses meet the definition, they are narrowed down based on other requirements under the research credit regulations. Therefore, it is expected Section 174 costs will be greater than the qualified research expenses used to calculate the research credit. Furthermore, it is possible a taxpayer does not meet the other qualifications required to take the credit but still has expenses meeting the definition under Section 174. In addition, merely forgoing the credit in 2022 does not mean a taxpayer does not have Section 174 expenses.
If a taxpayer has activities qualified for the credit, the credit may be even more important to help offset the increased tax liability as a result of this change.
When is the Guidance Being Issued?
It may take several months before comprehensive guidance regarding Section 174 is issued; however, there is no guarantee that it will be released by the end of the year.
What is the Impact on Software Development?
With the recent changes, Section 174 now encompasses software development costs, rendering much of the guidance provided in Revenue Procedure 2000-50 outdated. This revenue procedure had long served as the primary source of guidance regarding the tax treatment of software development costs, typically allowing full expensing.
Although Section 174 now includes software development costs, it does not provide a specific definition of “software development” or distinguish between software developed for internal versus external use.
Currently, the conventional understanding is that software development primarily refers to activities that result in new software features or enhancements, while activities related to software installation, configuration, and bug fixes/maintenance are considered non-development activities.
How is my State Affected by Section 174?
The treatment of Section 174 depends on the specific state. While the majority of states that enforce an income tax align with the federal treatment of Section 174, there are noteworthy exceptions. For example, California generally does not conform to the modifications introduced by the TCJA. Taxpayers who engaged in research and experimentation (R&E) activities in 2022 will need to collaborate closely with their advisors. This will enable them to assess their state filing requirements and how to proceed in each jurisdiction.
Do I Need to Extend My Tax Return for 2022?
For those affected by Section 174, we recommend that businesses and individuals consider extending their tax returns in anticipation of Congress retroactively restoring full research and experimentation (R&E) expensing for the tax year 2022, or in the event that Congress fails to act, the issuance of essential guidance by the IRS and Treasury. Additionally, opting for an extension could prove advantageous as it would grant taxpayers the opportunity to file a superseding tax return.
What Should I Do?
Most taxpayers have never accounted for their Section 174 expenses and may not have properly assessed the impact the rule change will have on their tax liability. The unfavorable tax impact can be mitigated through the R&D credit, so taxpayers may want to revisit such opportunities for the current tax year.
Continue the Conversation
If you have any questions about Section 174 Capitalization and what it means for your business, please reach out. We can help you navigate these new rules. You can also urge your Congressional leaders to take action by sending them a letter through the National Association of Manufacturers.